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Wednesday, June 5, 2013

Bulls and Bears Squaring Off at a Major Battle Line

Yesterday's outlook gave 55% odds to the idea of a wave (2) top for the S&P 500 (SPX), marked on the chart as either 1643 or 1647, and the market reversed strongly off the 1647 level, then declined all the way back to retest Monday's low. For the near and intermediate term, this is now a potentially dangerous setup for the market. I'm continuing to favor the bears for the foreseeable future, but since I'm not a perma-bear, I'm also looking for signals which could indicate a bottom. In this update, we'll discuss both arguments in detail.

There's an upward market bias inherent with the QE-Infinity program, and the market has rallied virtually nonstop since that cash started hitting the Primary Dealer accounts in November. The notable exception to this endless rally was the weeks leading into the fiscal cliff dilemma (late last year). As it turned out, during the end of 2012 the Primary Dealers were withholding that cash from the market, due to their discomfort with the entire situation. Keep in mind that a similar thing could happen at any point, so QE-Infinity in itself does not guarantee a market without corrections. Further, if liquidity is being destroyed (somewhere down the chain) faster than the central banks are creating it, then the market environment becomes deflationary.

All that said, I still don't favor the idea of 1687 being a long-term top, but as I wrote on May 23:

In conclusion, the long-term presently remains pointed higher, but that may be irrelevant at the moment. We can't see around every bend in the market, but most times we don't need to: the near-term appears to be pointed downwards, and the intermediate-term, while too early to confirm, also looks likely for further downside. This is not a bad time to behave defensively.

Though I've been bearish since 1687, my long-term bias remains bullish, and this leads to an interesting cognitive situation. I'm not sure how to put it into words exactly, but I'll try: I "want" to find a reason for this market to bottom, but I'm not seeing it yet. In fact, my work suggests that if the 1622 level fails, we could actually see a significant sell-off. Right now, the bull patterns I'm finding (from an Elliott Wave perspective) are obscure patterns that are generally low-odds, while the high-odds patterns continue to favor the bears, as they have ever since the reversal at the all-time high.

Long-time readers know that I attempt a feat many believe is "impossible" with these updates: I try to predict the market across virtually every time frame (short, intermediate, and long), three to four times each and every week. I'm bound to get some calls wrong, and I absolutely do -- but since early May, I haven't missed many and that puts me in a good psychological position right now as an analyst. I'm not talking about ego in this sense, although this may be something that only another public analyst can probably really understand. Basically, when you hit a top as well as I hit this one (my May target-2 for SPX was 1680-1690), then you have a lot of psychological wiggle room to really see what's going on afterwards, because you're not trapped by your prior bias/analysis. When you get caught looking the wrong way, you tend to try and find ways for the market to prove you right in the end (in order to justify the fact that you were screaming to buy at much higher prices, or to sell at lower prices).

It can be a pretty tough gig actually, and analysts don't get enough credit for the painful crises of conscience that (I assume) we all endure at times after a missed call. If you've ever wondered why analysts love to toot their own horns when they get a call right, it's not because they want everyone to think they "get every call right," it's because they're trying to compensate for the incredible guilt they feel over the calls they blew. A small handful of readers love to remind analysts of their bad calls -- but believe me, nobody needs to. We know our bad calls better than anyone, because those mistakes take up residence in our memories, especially late at night when the house is quiet and still. In fact, many of us remember our bad calls much better than we remember our good ones.

Moving from independent trader to public analyst over the past couple years wasn't an easy adjustment for me -- the challenges of each role are actually quite different. But I digress.

I think the market's in an interesting position here, from a number of different standpoints. In terms of sentiment, bearishness has increased recently, but the BTFD ("buy the friggin' dip!") mentality is still reflexively strong, and we've been hearing a lot of "buy the dip" talk the whole way down so far. This in itself bothers me, because I feel like the long trade has become almost too reflexive and easy at this point. I know that during last week, I was one of the few lone nuts suggesting we sell the bounces, and many were suggesting the opposite. Anecdotally, that tells me there are probably a lot of bulls now trapped north of 1650. What's most interesting is that even many bears seem afraid to sell into this rally. And why wouldn't they be, after being beaten to death since January? Maybe a better question is: could they, even if they wanted to? I know there are several popular bear subscription services who've recommended heavy short positions all the way up (some with stops I consider outrageous), and I can only imagine that many of their subscribers are dead broke by now.

So, my question is: are there even any bears left to sell short this market? Because if the only sellers remaining are bulls, there could be a problem. Short-selling gets a bad rap from some folks, but the reality is shorts provide an important layer of support for the market, because at some point down the line, shorts have to buy back whatever they sold. Additionally, shorts tend to trip all over each other trying to cover their positions en masse, which is why bottoms usually have the classic V-shape -- and shorts are generally the ones who kick-start the momentum for the next rally leg.

On the other hand, bulls all by themselves make "bad sellers" because they are simply trying to get out, often in a rush, and they have no requirement to buy back in; bulls can sit in cash or government Trashuries for as long as they want. As a result, a decline without short covering can be fast and brutal. Remember the last time the U.S. banned short selling (of 799 financials), in 2008? How did that work out? (Hint: not well; prices fell more than 12% over the next 14 days.)

So my bottom line point here is: While I've stayed bearish since the 1680-90 target was hit, I still "want" to find a reason for the market to bottom. I think a lot of people are feeling the same way -- and that tells me we have to be extremely cautious, because when everyone's looking the same direction, the market has a tendency to do the exact opposite. Let's take a look at the arguments for both cases.

Starting off with the bear case, we have a few patterns that aren't terribly encouraging for bulls, and which I first called attention to on May 30. The SPX chart below should be examined in conjunction with the NYSE Composite (NYA) chart shown later.

If we look at this purely from the "trade what you see" perspective, we find the cleanest wave count is the bearish nest of first and second waves shown below. I remain marginally in favor of this count, but I am quite alert to the fact that this is (suspected to be) a fourth wave decline, and fourth waves rarely follow the "most obvious" pattern. They usually turn infinitely frustrating at some point, and become all but impossible to predict.

Note the black "alt: (2)" as the current wave could become more complex. In either case, if the count shown in blue and red is correct, there should be downwards acceleration coming when 1622 is claimed. If there is no downwards acceleration on a breakdown, then we have to give weight to the "less obvious" wave counts. Again, I'll discuss this in a bit more detail on the NYA chart.

The hourly chart has now been updated with target 3 potential -- beyond that, there's been no change in a while.

Let's take a look at the bull case. The first indicator that begs attention is the McClellan Oscillator (NYMO), which is generally a very reliable oversold/overbought indicator. NYMO is approaching the edge of the buy zone, but this indicator can be a little early. I would not use this indicator as a stand-alone, but watch the price action for additional confirmation of a low (if appropriate).

So, what do we watch in the price action? Well, the cleanest index I've seen for the bull potential is currently NYA, so I've outlined what I'd look for heading forward -- given what's in the charts right at this exact moment, anyway. Note NYA made a new low yesterday, which I believe suggests SPX will ultimately do so as well.

In conclusion, in my opinion, the market is quite likely to make a new swing low, either directly or otherwise. Though I'm presently inclined to favor the bear case, I can't foresee exactly what will happen here, so I've tried to outline what I'll be watching. If we get a new low and a whipsaw, then I think bulls are in good shape -- but if we don't, this market has quite a bit of bearish potential energy stored up and is likely to see a solid sell off. Trade safe.

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